TFSA – Part III: Strategies

When you have a TFSA, an RRSP and an open investment account, which assets will ideally go in which accounts? These are general ideas to keep in mind while planning your TFSA contributions.

Once there are funds inside the TFSA, a huge benefit is that income and capital gains are not taxed. The practical application is that transactions no longer trigger tax consequences, much like inside an RRSP. A TFSA is very useful for high turnover trading. If you are investing (or speculating) using a strategy that frequently sells positions, it would result in realized gains and losses in an open investment account. Within an RRSP, the taxes are all paid at withdrawal. But in a TFSA, those gains are never taxed.

Generally, it is recommended to put fixed income (bonds and GICs) inside an RRSP and capital growth (equity) in an open investment account. There are two benefits to having the fixed income inside the RRSP: avoiding paying taxes on the income and keeping the slow growth in the RRSP. Since the RRSP withdrawals will eventually all be taxed, it makes sense to keep the total as low as possible. High-yielding securities could then pose a difficulty. Take, as an example, 5% preferred shares at $20. They will grow from $20 to $25 at maturity (often years in the future) and pay $1.25 per year taxable income each year. The RRSP will shelter the income, but it will also increase the value. A TFSA is the perfect account for an investment like this.

The general strategy in regards to types of income is: interest or business income, dividends, capital gains, return of capital. This assumes that you believe you will earn the same return in each case. Some examples of each type of income follow. Interest income is usually paid by bonds and GICs. Business income is earned from income trusts, although this will be taxed in 2011 and become like dividends. Dividends are usually paid on preferred shares and common shares. Capital gains come from growth in market value, usually from common shares or junk bonds. Finally, return of capital is often paid by REITs (real estate investment trusts). Because they have depreciation, the income they pay may not be taxable. It may eventually be classified as capital gains. The choice isn’t so simple, because you may expect greater growth from capital gains (buying growth stocks cheap), it may be best to hold that investment in a TFSA, instead of a GIC at 3%.

One strategy using TFSAs is available to all adult couples: income splitting. The government doesn’t really care who makes the TFSA contributions. If a couple has only one income, or two incomes in different tax brackets, it will probably make sense to have one spouse contribute to both TFSAs. That way, it is possible to use more TFSA room. If one spouse makes $20,000 per year and the other makes $80,000 per year, it doesn’t really matter who pays which bills. $10,000 can be used (in 2010) to contribute $5,000 to each TFSA, regardless of who earned the money. It is possible that, in retirement, there will be enough money in each TFSA that the couple can choose who will make their other withdrawals in order to minimize the total tax bill.

Canadians now have more ways to save tax while saving and investing for their future. Each has distinct benefits and uses. The RRSP offers deductions, and I recommend making an RRSP contribution first if your income is over about $40,000. Many Canadians have debt, and I recommend paying down debt before making a TFSA contribution. This is especially true if the TFSA would hold fixed income and the debt has a higher interest rate. A TFSA is usually the lowest priority, unless it is for short term savings or for a high-yielding investment. In the comments, please share how you use your TFSA differently than your RRSP and debt repayment.

Robert is a Certified Financial Planner (CFP®) in Calgary who develops financial plans and also gives objective advice regarding all types of savings and investment products. He believes that not having money worries can allow people to spend their time in other meaningful areas of their life. Robert is married, has three children and is involved in his church, in his community association and in the school. Robert is on track to retire at age 42, although he and his wife plan to change careers and work for the benefit of children.

12 thoughts on “TFSA – Part III: Strategies”

  1. One question that just popped into my head. What happens in the event of one spouses death? Is the money taxed when transferred to the spouse or estate? Or does it remain tax free?

  2. It will be interesting to see the evolution of the TFSA once the contribution rooms expand. As you mentioned it would be an ideal place to perform high frequency trading. The problem however is that with a $5000 maximum, the commissions prove to eat up too much of the transaction. Once the contribution room grows to say $50,000 it will be interesting.

    2010 is all about debt reduction so the TFSA will go unfunded this year, unless very good thing happen.

  3. Financial Student: That’s a great question. A TFSA has two options, a “successor holder” or a “beneficiary”.

    Successor Holder means you named only your spouse as the beneficiary, in which case the TFSA simply passes to the spouse intact. The spouse may then own two TFSAs.

    When a TFSA holder dies and the spouse is not the successor holder, the entire amount is deemed disposed at fair market value and the TFSA is ended. Any future income or growth is taxable to the estate or beneficiaries.

  4. One thing I noticed in my research on TFSAs has to do with residency. If you become a non-resident of Canada, you can maintain your TFSA, but you accumulate no contribution room (much like an RRSP). Growth, income and withdrawals are still tax-free and a withdrawal still results in increased TFSA room the following year. That is the only case in which you can make a TFSA contribution while non-resident.

  5. “It is possible that, in retirement, there will be enough money in each TFSA that the couple can choose who will make their other withdrawals in order to minimize the total tax bill.”

    What does that mean exactly? I thought there is no tax on withdrawls. Also, I heard that if a single spouse contributes to both TFSAs that’s fine, even if the other spouse withdraws the money as long as the 2nd spouse doesn’t reinvest it (then attribution rules would kick in).

    I’d appreciate learning more about this, because I contribute $10k/year to both our TFSAs. I even have POA setup on her TFSA so that the 2nd TFSA account shows up right in TDW for the ultimate convenience of transferring funds in/out online.

  6. Ray: You’re right that either spouse can contribute to the TFSA, and you’ve given a good example. It’s one of the few ways to legally get money earned by one spouse into the account of the other spouse.

    To address the sentence you quoted, there is no tax on TFSA withdrawals. It was the flexibility on other taxable withdrawals, such as RRIF or LIF payments, that I was referring to.

    Suppose when you retire, you have a pension, a RRIF and a TFSA. Your spouse has a RRIF and a TFSA. You draw your income ($5000/mo) from the pension ($2000/mo, required) and the RRIF ($1000/mo) and your wife from her RRIF ($2000/mo), to make use of the lower tax brackets. Then, one year, you decide to return to work for half the year. Between your pension income and employment income, you have more money than you need to spend for six months, so you stash the employment income in the TFSA. For the last half of the year, you need more than just pension income to live on. Don’t take the money from the RRIF. Increase your wife’s RRIF up to the top of the tax bracket ($40,000/yr Federal 15%), then take money out of your TFSA. This will avoid the higher rate of taxes in this temporary situation.

    It’s a bit complex and not a very likely scenario. But I value the flexibility TFSAs offer (“Do I want taxable or tax-free income this month?”). And it makes an argument to keep some investments outside of RRSPs, in the TFSA.

  7. Ray: You said, “…the other spouse withdraws the money as long as the 2nd spouse doesn’t reinvest it (then attribution rules would kick in).”

    That’s a very conservative interpretation. In all the information from the CRA that I read, attribution stops as soon as the spouse deposits it to the TFSA. I even phoned the CRA and they stressed the same thing. Which suggests a strategy.

    Suppose you earn 15% return each year. Last year, you gave your wife $5,000 to contribute to a TFSA and now it’s worth $5750. You give her another $5000 in January and by December she has $12,362 in her TFSA. She can take it all out tax free. The next month, January, you give her $17,362 to put in her TFSA. You’ve now given her $27,362 without attribution. She now has $12,362 in an open account and $17,362 in the TFSA, which is worth $20,000 by the end of the year. She can take out that $20,000 in December, then in January you can give her another $25,000.

    This could go on until you get your accounts even, so that you both have similar levels of taxable investment income (open accounts). This strategy is most applicable to people who have maxed out their RRSPs (maybe through generous pension plans) and have imbalanced open accounts.

  8. Like I said, as long as all her withdrawls aren’t used for further investments then it might just work (according to the financial advisor at TD Canada Trust).

  9. After a bit of googling, I didn’t find anything official on whether or not the attribution rules kick if a TFSA withdrawal is re-invested in an open account by the wife (as described in the above example).

    The closest I found was this interpretation on the Building Wealth site here:

    It seems the government anticipated this loophole by adding a line that says the attribution rules “will not apply to income earned in a TFSA that is derived from such contributions”.

    Note the phrase: “in a TFSA” which suggests that if the money is withdrawn by the spouse and then reinvested the attribution rules will kick in. At some point in time, we may see a court challenge on this one.

  10. Ray suggests that you cannot withdraw TFSA funds that were made by a higher earning spouse, then invest it outside the TFSA and avoid attribution rules. But it seems to me that you could at least remove the earnings. Suppose my higher earning spouse has made all my contributions ($10,000). Then, let’s say I double the funds through my investments, and on Dec 31, I remove $10,000 of the $20,000 in the account. I then place this in my non-registered investment account. Attribution rules do not apply to secondary income (i.e., income from income). Thus, I have now $10,000 to invest which was not contributed by my spouse, and my higher earning spouse can now contribute $15,000 to my TFSA on Jan 1. Then, the new spousal contribution base in the TFSA is $25,000 and as long as leave these funds in the TFSA, I should be able to remove any earnings and invest them without attribution rules applying.

  11. “Within an RRSP, the taxes are all paid at withdrawal. But in a TFSA, those gains are never taxed.”

    There is one grey zone with this rule. If you are a very active day trader, CRA may consider the income as business income and tax accordingly. I’m not sure there has been a tax court decision on this yet but once it happens, everyone will know.

    For the record, I’m not a DT.

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